Japan's Prime Minister and the leader of the ruling Liberal Democratic Party (LDP), Shinzo Abe, points to a reporter during a news conference following a victory in the upper house elections by his ruling coalition, at the LDP headquarters in Tokyo July 22, 2013.

TOKYO (Reuters) - Japan's most significant fiscal reform in years - a planned increase in the country's sales tax - could be delayed or watered down in a move that might rattle financial markets and amount to an own goal for the prime minister.

Despite holding the strongest political mandate of any prime minister in years, there are signs Shinzo Abe is seriously rethinking the plan out of concern it could derail a nascent economic recovery he has crafted with an aggressive policy mix, dubbed Abenomics.

Abe says he will decide in the autumn whether to proceed with the first part of the two-stage plan after gauging the state of the economic recovery, especially GDP data that is due on Sept 9. The tax, similar to general sales tax and value added tax in other countries, is due to rise to 8 percent in April 2014 and then 10 percent in 2015.

Abe does not want to raise the tax, given the likely economic and political repercussions, but he understands the risks of upsetting the markets by giving the appearance of backtracking on promised reform, said a person involved in crafting economic policies. At 5 percent, Japan and Canada have the lowest equivalent consumption taxes in the Organisation for Economic Co-operation and Development, OECD data shows.

The stakes in Japan are high. The tax hike was passed into law last year with the support of Abe's current coalition parties and the previous government and is meant to be the first step toward repairing Japan's tattered finances. However, the law also requires the government to judge the economic conditions before giving the final go ahead.

Reneging on fiscal reform could hit investor confidence, which has allowed Tokyo to borrow money cheaply even though its $5 trillion public debt, well over twice the nation's annual economic output, is the heaviest burden in the industrial world.

At the same time, Abe has stressed that his top priority is to rouse Japan from 15 years of deflation and tepid growth through his Abenomics programme of heavy government spending, massive monetary easing and promises of a longer-term growth strategy.

Abe himself admitted the thorny dilemma just hours after scoring a landslide win in upper house elections on July 21 that gave his ruling bloc a clear parliamentary majority.

"It will be a difficult decision," he said of the looming tax choice.

"The economy is just starting to recover and now is the best chance for Japan to emerge from deflation," Abe said. "I don't want to lose this chance. At the same time, markets are watching (our progress) on Japan's fiscal reform."

SPLIT

Despite his electoral triumph, Abe's team is split.

A small number of vocal reflationists, such as cabinet office adviser Koichi Hamada, say Abe should prioritise recovery and go-slow on raising the tax. Pitted against them, the Finance Ministry says it is vital for Japan to show markets and trading partners that it is serious about putting its fiscal house in order.

Japanese media reported on Saturday that Abe had instructed his government to study the impact on the economy and prices of four tax-hike options, including sticking with the existing plan, raising the rate 1 percentage point a year for five years and delaying the hike entirely.

Abe, speaking at a news conference on a visit to Manila, said: "I haven't yet issued any instructions to come up with several proposals."

Government officials also say they haven't received any formal orders to draw up fresh scenarios, although an advisory panel to the premier had already been mandated to study the impact of the current plan on the economy and prices.

Public opinion may play to the advantage of the reflationists.

A survey of 902 people in the Nikkei business daily, conducted just after the election, found only 11 percent supporting the existing plan, compared with 58 percent who favour "flexibility" in the timing or scale of the increase and 27 percent who oppose raising the tax at all.

History too provides a cautionary tale for Abe, who got a rare second chance at running the government in December.

Noboru Takeshita, the premier who forced the first sales tax through parliament in 1988, and Ryutaro Hashimoto, who raised it to 5 percent from 3 percent in 1997, were driven from office as their public support collapsed - although other problems also plagued both men. The decision to double the tax contributed to the defeat of Abe's predecessor, Yoshihiko Noda.

Adviser Hamada, a 77-year-old emeritus professor at Yale University and a key member of Abe's brain trust, told Reuters on July 23 that Japan needed much more evidence of a sturdy recovery before raising the tax.

The economy, which grew at an annualised rate of 4.1 percent in the first quarter - the fastest among Group of Seven industrial powers - needs to maintain similar growth for two more quarters before enduring a tax hike, Hamada said.

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He set the bar higher still, saying he is pushing Abe to wait not only until growth picks up but until employment improves, ensuring a firmer footing for the recovery.

The government should wait until unemployment falls to 3 percent from around 4 percent now and job seekers outnumber job offers "in all regions" of the country, Hamada said.

Although the latest data shows there were 90 seekers for each 100 job offers in May nationally, only four of Japan's 10 regions have more labour demand than supply.

It is unclear how much influence Hamada has on fiscal policy, but the views of the reflationists might "have significant influence on Abe's thinking on this subject," said former Bank of Japan deputy governor Kazumasa Iwata, head of the prominent think tank, the Japan Centre for Economic Research.

Some government officials are keen to start fiscal reform, privately worried that changing the tax plan would endanger Japan's promise to halve its budget deficit - excluding debt-financing - from fiscal 2010 levels by fiscal 2015 and balance the budget five years later.

They say raising the tax in incremental steps each year could be too easily derailed, since the politically sensitive hikes would have to be approved for five years in a row - with national elections scheduled in three years.

Finance Minister Taro Aso has strongly insisted on sticking with the tax-hike plan, saying it is an international promise. Still, Aso signalled last week he is willing to soften the economic blow by offering another dollop of fiscal stimulus.

The Japanese government-bond market, which lets Abe's government borrow 10-year money for less than 0.8 percent, would be hit hard if Abe changes the sales-tax plan, said Tadashi Matsukawa, head of Japan fixed income at PineBridge Investments.

"The whole of Abenomics would basically crash under that scenario," he said, adding he thinks it unlikely Abe will change the plan.

Iwata, the former BOJ deputy governor, told Reuters that if Abe postponed the agreed tax hike, that would endanger the rest of the fiscal-reform schedule.

"If Japan can't raise the tax rate even when the economy is in good shape, that may lead to market distrust over Abe's governance," Iwata said. (Reporting by Sumio Ito, Yuko Yoshikawa, Hitoshi Ishida, Kaori Kaneko, Leika Kihara and Lisa Twaronite; Writing by William Mallard; Editing by Neil Fullick)

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